Limits to Arbitrage During the Crisis: Funding Liquidity Constraints and Covered Interest Parity

Arbitrage normally ensures that covered interest parity (CIP) holds. Until recently, excess profits, if any, were documented to last merely seconds and reach a few pips. Instead, this paper finds that following the Lehman bankruptcy, these were large, persisted for months and involved strategies short in dollars. Profits are estimated by specifying the arbitrage strategy as a speculator would actually implement it, considering both unsecured and secured funding. Either way, it seems that dollar funding constraints kept traders from arbitraging away excess profits. The claim finds support in an empirical analysis drawing on several novel high frequency datasets of synchronous quotes across securities, including transaction costs.